BOE’s Euro-Zone Inflation Conundrum

Is the state of the Spanish economy driving the Bank of England’s monetary policy?

U.K. inflation and wage pressures continue to be weak, justifying the Bank of England’s preference for lower-for-longer interest rates notwithstanding strong domestic growth and a dangerously over stretched property boom.

Undoubtedly, the absence of price pressures against the backdrop of strong growth reflects continued spare capacity in the economy. But there are external factors involved as well, not least the state of the euro-zone economy.

High levels of unemployment in the likes of Spain, Italy, France, Greece and elsewhere in the single currency region have driven job seekers to the U.K., keeping a lid on wage growth. At the same time, that weakness in domestic euro-zone demand is also helping to hold back prices more generally.

Unfortunately those were the same dynamics that prevailed in the years leading up to the financial crisis–which hit the U.K. harder than many other economies. Which makes Bank of England policy setting particularly difficult.

Consumer prices grew at just 1.6% over the year to July, against an expected rise of 1.8% and following a rate of 1.9% in June. Factor in a big drop in producer input prices for the same month–down 7.3% on the year–together with softness in commodity prices, not least oil, and the prospects of inflation hitting the BOE’s 2% target over the near term recede.

Yes, sterling’s recent decline as investors react to a diminishing likelihood of a near-term interest rate hike will probably put a floor under inflation. But, by the same token, any coming rise in price pressures is likely to be partly offset by renewed currency strength.

So the risk of a near-term breach of the BOE’s remit isn’t likely to be the immediate driver of monetary policy.

But the lesson of the pre-crisis boom won’t be forgotten.

Then, mass migration from Eastern Europe allowed unemployment to fall to multi-decade lows without triggering a wage spiral–the migrants wouldn’t be counted as jobless but were available to the workforce.

Together with deflationary forces emanating from China’s rapid industrialization, the U.K. economy was allowed to overheat–both household and government consumption were roaring away, while house prices also boomed–without triggering domestic inflation.

It did encourage a hefty build-up of household debt as well as a rampant growth in financial service sector leverage.

The risk is that once again interest rates are left too low for the domestic economy in light of international factors, which would lead to yet another set of dangerous imbalances. And lately, there are signs that U.K. household deleveraging is reversing and debt is building back up, while borrowing is growing in other sectors of the economy too. At the same time, the appetite for risk assets has taken off too.

Whether the BOE allows inflation to undershoot once the economy hits its unemployment target is another question. But as long as the euro zone continues to slip in and out of recession and there are legions of unemployed Spaniards, Greeks and Italians eager to refine their English, the U.K. economy risks a replay of what happened a decade ago.